Accounting rate of return (ARR) is also known as average rate of return. ARR is based upon accounting information rather than on cash flow. In other words, Accounting rate of return (ARR) refers to the rate of earning or rate of net profit after tax on investment.

ARR consider profitability rather than liquidity. Under ARR technique, the average annual expected book income is divided by the average book investment in the project.

ARR = (Average net income/Average investment) x 100Where,Average net income= Total net income/No. of yearsAverage investment= Net investment/2

*Calculation Of Accounting Rate Of Return (ARR)*

Illustration:

The initial investment of the project is $30,000. The net profit after tax is as follows:

Year……………………….Net profit after tax($)

1………………………………25000

2………………………………30000

3……………………………….20000

4………………………………..25000

5………………………………..40000

Required: Accounting rate of return.*Solution*

Calculation of ARR:

ARR = (Average net income/Average investment) x 100

= (28000/15000) x 100 = 18.67%.

Where,

Average net income = Total net income/No, of years

= 25000+30000+20000+25000+40000/5 = 28000

Average Investment = Net investment/2 = 30000/2 = 15000

*Decision Rules Of Accounting Rate Of Return (ARR)*

**A. If projects are independent**

Accept the project which has higher ARR than standard.

Reject the project which has lower ARR than standard.**B. If projects are mutually exclusive**

Accept the project which has highest ARR

Reject other projects.

*Advantages Of Accounting Rate Of Return (ARR)*

1. ARR is based on accounting information, therefore, other special reports are not required for determining ARR.

2. ARR method is easy to calculate and simple to understand.

3.ARR method is based on accounting profit hence measures the profitability of investment.

*Disadvantages Of Accounting Rate OF Return (ARR)*

1. ARR ignores the time value of money.

2. ARR method ignores the cash flow from investment

3. ARR method does not consider terminal value of the project.

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